Vanguard downgrades global economic growth
In the rapidly changing environment that has characterized 2022 so far, we have downgraded our forecasts for GDP growth for the United States and China and revised our views on inflation and monetary policy for the euro area. But we believe these economies will likely avoid a recession this year, and our forecast for Federal Reserve policy is unchanged.
“We’ll see slower growth going forward because of a myriad of factors,” said Andrew Patterson, Vanguard senior international economist. “But our views on macro fundamentals are changing in regard to magnitude, not in direction.”
United States: Slower but continued growth
We’ve revised our outlook for full-year U.S. GDP growth to roughly 2%, down from around 3.5% at the start of the year.1 Three factors that will likely persist through 2022 drive our downgrade:
- Financial conditions have tightened to a level that likely restricts growth. Most of the tightening has come through higher lending rates. Falling equity markets have also contributed. We believe conditions have tightened significantly more than what’s implied by the market’s current pricing of future federal funds rate increases. Hikes eventually might even go beyond the neutral policy rate (when the Fed’s key interest rate would neither stimulate nor restrict the economy), which we currently see as around 2.5%.
- Incomes aren’t keeping pace with inflation, a drag on what have been solid consumer fundamentals. We believe that wage growth will remain elevated but will only catch up to levels of core inflation late in 2022, and will continue to lag headline inflation, which includes the effects of volatile food and energy prices.
- The foreign demand outlook has deteriorated. The war in Ukraine is hurting European economies, and persistent COVID-19 outbreaks have caused growth in China to fall well below trend. We expect U.S. net trade to be pressured as a result. A 1.5% U.S. GDP contraction in the first quarter was in no small part driven by a reduction in net trade, as exports declined and imports increased.2 The simple math of the unexpected first-quarter decline in U.S. GDP puts downward pressure on full-year GDP.
“We’re tempering expectations about growth, but that doesn’t materially change our views about the labor market or inflation at this point,” Patterson said. More moderate growth will keep the unemployment rate from falling below 3% in the near term, and high labor demand should normalize more rapidly. We continue to expect that inflation will remain elevated but falling, supported by healthy demand, a tight labor market, and supply constraints that will linger throughout the year. Persistently elevated energy prices have grown as an additional risk factor, and we will monitor that closely.
“The growth rate also doesn’t change our view on Fed monetary policy for what remains of 2022,” he added. Vanguard expects the federal funds rate to increase another 100 to 150 basis points (bps), on top of the 75 bps earlier in the year. The rate hikes will come alongside a reduction in the Fed’s balance sheet.
Europe: Spiking inflation means higher rate hikes
The story is a bit different in the euro area.
“Our European economists are anticipating more interest rate hikes in 2022 than originally forecasted,” Patterson said. “The European Central Bank (ECB) is now more focused on fighting inflation, which is spiking into double-digit territory on a quarter-over-quarter basis.”
The changing picture for Europe:
- Europe is slowing down, but recession isn’t likely unless Russian natural gas imports end. Euro area growth will likely be around 2.5%, lower than Vanguard’s forecast of around 4% at the start of the year. Recession is not likely this calendar year unless there is a hard stop to Russian gas imports.
- Annualized headline CPI is tracking above 15% on a quarter-over-quarter basis. Vanguard has increased its inflation forecast for the full year to an average of 7.5% to 8%, up from our earlier 6.5%–7% forecast. Spikes in prices for food and energy are the most acute drivers, but inflation has become broader across sectors, especially in services.
- The ECB has acknowledged the changing dynamics. Key officials have been signaling more openness to aggressive rate hikes.
- We now forecast 100 to 125 bps of rate hikes in 2022, higher than our previous forecast of 50 bps. As such, we expect the ECB’s key deposit rate to turn positive for the first time since 2011 and to end the year in a range of 0.5% to 0.75%.
- We expect the policy rate to be above neutral (around 1.5%) by the middle of next year and to reach 2.5% by year-end 2023. This is about 50 bps higher than what’s reflected in current bond market pricing.
China: 2022 growth target is likely to be missed
“We’re predicting a 2022 growth rate just above 3% for China, which is lower than consensus and considerably lower than the central government’s target of around 5.5%,” Patterson said. “Obviously that’s still a healthy growth rate, but for China, that will feel like a recession from what they’re used to.”
The factors driving the downgrade:
- China’s zero-COVID policy has had a significant impact. Economic indicators have been weaker than expected in the second quarter, driven by the COVID-19 lockdowns; this will weigh down the full-year forecast. However, we anticipate that May was the trough. A related article looks at the effects of China’s zero-COVID policy in greater detail.
- Don’t expect a repeat of the 2021 recovery. Although China should recover during the second half of 2022, it will not be anywhere close to the robust pace seen in the second half of last year. There are too many headwinds offsetting anticipated stimulus.
- Future COVID outbreaks can’t be discounted. More pressing is that China’s continuing zero-COVID policy will mean that any future outbreaks will dampen economic activity.
Our revised forecast for the full year is a downgrade from the 5% we anticipated at the start of the year. It’s also lower than consensus views that generally range from 4% to 5%.
Impact on global economy and Fed monetary policies
Although global recession is unlikely, things are in flux and the Federal Reserve will be watching indicators carefully in forming future monetary policy. The chart reflects Vanguard’s modeling on how aggressive the Fed would be in hiking short-term interest rates depending on various scenarios. For more information, see the Vanguard research paper Federal Monetary Policy: Is This Time Different?
The federal funds rate in select scenarios
Notes: This figure describes the Fed’s rate hike path under each scenario presented. The forecasts are obtained from Vanguard’s model estimates. A combination of model estimates and subjective analysis is used to estimate the forecasts’ terminal rate and timing under each scenario.
Sources: Adapted from Federal Monetary Policy: Is This Time Different? Vanguard model estimates based on data from Refinitiv, Moody’s, and Bloomberg.
The Fed has to find a balance between reining in inflation and tempering the pressures of a tight labor market. Developments that weigh heavily on economic activity would likely cause the Fed to slow its pace of rate hikes.
Like the Fed, Vanguard will be closely monitoring this ever-changing situation.
“We’re always revisiting our views in any economic environment, but the fact that we’re revising so many of our global perspectives now speaks to the uncertainty underlying today’s environment, given the risks surrounding geopolitics, policies, and supply chains,” Patterson said.
1Measured on a Q4/Q4 percent-change basis.
2Imports are subtracted from GDP because they reflect goods produced outside the United States.